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Chapter 12 – Strategy and the Analysis of Capital Investments
Reading 12-2: How ABC Was Used in Capital Budgeting
This article presents a case study on the difference that ABC makes on the investment decision of a new
project. A business forecast signaled “Go” to an interactive TV project, but the ABC analysis said, “Stop.”
The article discusses the utilization and limitations of activity-based costing (ABC) in capital budgeting
including capacity to predict operating and capital costs, benchmarking model and steps in using ABC in
capital investment project.
Discussion Questions:
Question 1: What is the general business case approach to capital budgeting?
A general business case approach generally is done at a broad strategic level with few supporting
level. Figure 1 in the article provides an overview of the business case approach to capital budgeting.
Question 2: How does an ABC model approach to capital budgeting differ from the general
business case approach?
The ABC model approach started with forecasts based on detailed benchmarked data. Using
benchmark assumptions, the ABC approach developed a deployment schedule and a transaction
Question 3: What are the roles of value chain in capital budgeting?
The specification of value chain allows identifications of major activities in each of the business
Question 4: List primary advantages and limitations of an ABC approach to capital budgeting.
Among advantages of an ABC approach to capital budgeting are:
1. The pro forma analysis of the business processes and activities with linkages to revenue and cost
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Chapter 12 – Strategy and the Analysis of Capital Investments
Reading 12-3: Calculating a Firm’s Cost of Capital
This article provides an overview of the theory and practice associated with the process of estimating a
firm’s discount rate for capital-budgeting purposes. The discount rate for “average-risk” projects is
defined as the firm’s weight-average cost of capital (WACC). The authors present three different methods
for estimating a firm’s WACC. These methods are applied to data from both Microsoft and General
Electric. The authors conclude that careful judgment and the use of sensitivity analysis are important to
the estimation process.
Discussion Questions
1. For what managerial and/or decision-making applications is there a need to generate a firm’s
cost of capital? That is, what are the primary applications of the firm’s cost of capital?
A company’s cost of capital is used in a variety of decision-oriented contexts, such as: to evaluate
merger and acquisition decisions; for long-term decision-making (i.e., to make capital budgeting
decisions); to calculate Economic Value Added®; for equity valuation purposes; in accounting for
2. Explain the primary components of a firm’s weighted-average cost of capital (WACC).
The term “cost of capital” refers to the cost of obtaining investment capital. In general, funds can be
obtained from two sources: debt and equity. Each of these sources (and subdivisions thereof) has an
associated after-tax financing cost. As the name implies, a weighted-average cost of capital (WACC)
3. What methods are available for estimating a firm’s cost-of-equity component of its WACC?
Explain the elements of each of these two methods.
For listed companies (i.e., companies whose shares are traded on an organized exchange), one approach
to estimating the cost of equity is to use the single-factor capital asset pricing model (CAPM). This
model is presented as Equation 3 (p. 14) of the article. This model requires an estimate of the
sensitivity of return for a given stock, relative to the return on a market portfolio. Alternatively, listed
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4. Explain how uncertainties are handling in the process of estimating a firm’s WACC (or, more
generally, its discount rate).
As implied by the above discussion, there is both art and science involved in estimating a company’s
WACC. Various assumptions are made in estimating the components of WACC. Thus, it is appropriate
to refer to a company’s estimated WACC. The authors of this article provide two suggestions for
dealing with uncertainties regarding the estimation process:
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Chapter 12 – Strategy and the Analysis of Capital Investments
Reading 12-4: What a University Can Teach You About Choosing Capital
Projects
This article provides a discussion of issues related to the analysis of capital expenditures in a not-for-
profit (i.e., university) setting. Of particular interest is the development of a model that, the authors
maintain, can be used to assess the strategic value of such expenditures. Thus, proposed capital
expenditures are evaluated in terms of their impact on the university’s mission, vision, and strategy. As
such, the model in this paper serves as an alternative to the multi-criteria decision models (such as AHP)
discussed in Chapter 12 of the text.
Discussion Questions
1. What is the primary business (or, managerial) issue addressed by the authors of this article?
The article looks at the capital budgeting decision process as applied by governmental and not-for-profit
(NFP) organizations. In such cases, the use of conventional discounted cash flow (DCF) decision
models is problematic since investment projects in this context many times have cash outflow but not
2. What solution do the authors propose for the business problem you identified above in (1)?
The authors propose a model that they developed and used at the University of Vermont during the
summer of 2007 to improve the linkage of the capital budgeting decision process to the university’s
3. Provide an overview of how the model identified above in (2) was actually used in practice (at the
University of Vermont).
The model developed by a small team of MBA students and faculty members is presented as Figure 1
(page 40) and was the basis for the project-ranking system that could be used by university
administrators. This model consists of 13 scoring criteria divided into four categories: Guiding Factors,
Impact on Critical Players, What We Do, and Project Drivers. For example, under category 1, there are
two criteria that were used to evaluate project proposals: (1) extent to which a given project helps
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Chapter 12 – Strategy and the Analysis of Capital Investments
Reading 12-5: Improving Capital Budgeting Decisions with Real Options
This article provides a non-technical introduction to the topic of real options, including how capital
investment analysis can be improved by incorporating the effects of real options that might be embedded
in such projects. For a fuller discussion of this topic, including tips for incorporating real options into the
accounting curriculum, see the following: D. E. Stout, H. Qi, Y. A. Xie, and S. Liu, “Incorporating Real
Options into the Capital Budgeting Process: A Primer for Accounting Educators,” Journal of Accounting
Education, Vol. 26 (2008), pp. 213-230.
Discussion Questions
1. Define the terms financial options, real options, and real assets. In what sense are real options
similar to and distinct from financial options?
Financial options are securities that provide holders with the opportunity to manage risk and capitalize
on new information revealed in the market over time. Financial options associated with new issues of
securities include: stock warrants/options (i.e., options to purchase shares from the company at a
stipulated price prior to an expiration date), convertible bonds (i.e., bonds for which the holder can
exchange for a specified number of shares of stock), and callable bonds (i.e., bonds that the issuing
2. Describe the primary types of real options that might be embedded in a capital expenditure
project.
For discussion purposes, we might classify real options into four categories, as follows:
The former gives the holder the right, but not obligation, to sell a stock (for the exercise price) on or
before the exercise date. The latter gives the holder the right, but not obligation, to buy stock at a
specified price (called the strike price or exercise price) before the exercise date.
Investment-timing options and expansion (growth) options are similar to call options, while
abandonment options and production output options are similar in nature to put options.
3. What argument do the authors make as to a recommended role of real options analysis for
purposes of evaluating capital investments?
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Chapter 12 – Strategy and the Analysis of Capital Investments
Conventional discounted cash flow (DCF) models used to evaluate capital investment proposals are
static in nature in the sense that they assume management acts passively after an initial investment
decision is made. As such, conventional DCF models effectively assign a value of zero to any real
4. Provide an overview of the primary example used as the basis for discussion in this article.
The investment decision being contemplated by a business was to purchase a hybrid vehicle or a
gasoline-powered vehicle. When evaluated using a conventional DCF analysis, the purchase of a hybrid
vehicle was rejected because the estimated net present value (NPV) of this alternative was negative (at a
10% discount rate—see Equation 1). The cash inflows associated with this proposed investment were
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Chapter 12 – Strategy and the Analysis of Capital Investments
Reading 12-6: Using Monte Carlo Simulation for a Capital Budgeting Project
Although many types of analyses are useful in determining the scope and possible success of a project,
Monte Carlo simulation actually helps managers understand and visualize risk and uncertainty by
mapping all possible outcomes of a project.
Discussion Questions
1. What was the managerial decision discussed in the article?
A physician’s practice group (medical doctors) was considering the purchase, installation, and
2. Define the term “Monte Carlo Simulation” and distinguish this (MCS) from sensitivity analysis
and scenario analysis (both of which can be done in Excel).
Monte Carlo Simulation is a sophisticated managerial tool that enables decision makers to visualize
risk and uncertainty in complex decisions, such as capital expenditure decisions (illustrated by the MRI
scanner example). Essentially, that value of each factor in a decision model (e.g., NPV, which is used to
evaluate the financial viability of proposed long-term investments) is represented in the form of a
Other, but cruder, methods of handling risk and uncertainty include:
Monte Carlo Simulation (done, e.g, by Crystal Ball or @RISK—an Excel add-on) allows the decision
maker to deal simultaneously with changes in the value of one or all input values. Further, one can
incorporate in the simulation analysis statistical relationships—that is, correlations among—the various
input factor to the model.
3. Describe four of the variables that entered into the decision discussed in the article. (That is,
which items were defined in the analysis as “assumption cells”?)
Key variables associated with the proposed MRI scanner investment are offered in Table 1 of the
article. These variables—all of which affect the estimated NPV of the proposed investment—are as
follows:
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